Speech by SEC Commissioner:
"Principles to Help Guide Financial Regulatory Reform" — Remarks Before the Institute of International Bankers

by

Commissioner Elisse B. Walter

U.S. Securities and Exchange Commission

Thank you for that kind introduction. This program certainly has an impressive roster of speakers and I am honored to be with you today to participate in this important discussion regarding the global financial crisis and the future of regulatory restructuring and reform. I look forward to sharing my thoughts with you on these issues. Please keep in mind, however, that my remarks today represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or members of the staff.1 Also, like my fellow regulators and, I suspect, most of you, my thoughts on these matters are evolving.

Introduction

Let me begin with the old Chinese proverb, "May you live in exciting times." This was actually not meant as a blessing, but as a curse. Before I rejoined the SEC last year, I never could have guessed that I would be serving as a Commissioner in the midst of the biggest financial crisis since the Great Depression. Rather than feeling cursed, however, I look at this crisis as presenting an opportunity to make needed changes in the structure of financial regulation.

Calls for comprehensive reform of our financial regulatory system have intensified in the past year.2 Indeed, in the past few months alone, we have seen several major proposals to modernize the outdated U.S. financial regulatory system from, among others, the Government Accountability Office, the Congressional Oversight Panel for the Troubled Assets Relief Program, and the Group of Thirty.3 These reports do not always recommend the same solutions, but they all recognize both that our financial markets have changed dramatically in the past 25 years and that financial regulation has not kept pace with these changes. Globalization, consolidation within financial sectors, conglomeration across sectors, and convergence of institutional roles and products, coupled with financial innovation, have seriously tested the ability of regulators to keep up.4 As my fellow Commissioner, Kathleen Casey, remarked to you last November, this presents an enormous challenge to regulators, policymakers, legislators, and other market participants.5

In this brief talk, I cannot cover potential regulatory reform in depth. Instead, what I would like to do is share with you five principles; I believe that these principles, among others, should guide our legislative and regulatory efforts. I realize that the devil is in the details, and that we may not always agree. However, if we keep these principles in mind, I believe we will be in a better position to consider the merits of all the options going forward.

Principles of Regulatory Reform

Principle 1: The objectives of managing systemic risk and protecting investors should both be maintained and pursued in a balanced manner.

Much of the focus in recent discussion of regulatory reform is on the need to address the weaknesses in the current structure for identifying, assessing, and addressing broader systemic risks to the financial market as a whole. I fully support efforts to address systemic risk in the markets, but I also strongly believe that they should neither erode the central role that the Commission plays in protecting investors nor confine its role to a retail sales perspective. In this, I share the view of our new Chairman, Mary Schapiro, who noted when she was still at FINRA that "both the management of systemic risk and the protection of individual investors are important to the smooth operation of our financial markets.… [T]hey represent two sides of the same coin."6

Put another way, as a market regulator, the Commission must have a deep and broad understanding of the workings of the securities markets and the institutions and individuals who participate in them. To be fully effective, the agency must be able to obtain comprehensive knowledge of the markets and oversee the risk management practices of those firms dealing with the investing public. If the mission of the Commission were to be narrowed to a single type of function, such as acting solely as a consumer or investor protection agency, a number of things could happen: (i) the Commission could lose the expertise it now has, (ii) it could become distant from the markets and its knowledge base, and (iii) it might lack the authority necessary to obtain a full understanding of the trends and risks in the markets that may pose threats to investor interests.7 Each of these potential consequences would harm investors, not benefit them.

Principle 2: The current regulatory framework should be restructured to eliminate gaps and overlaps and to increase market transparency, so that important products and market actors are not beyond the oversight of regulators.

The United States has a Balkanized structure of financial regulation, what Professor John Coffee has called a "crazy-quilt structure of fragmented authority."8 Currently, there are myriad federal and state bodies responsible for regulating various components of the financial markets, but their divided and sometimes overlapping jurisdictions create inefficiencies and may also generate an overly narrow regulatory focus. The truth is that reliance on interagency cooperation can never be a true substitute for comprehensive jurisdiction. Nor is it sensible for a regulatory system to incorporate unnecessarily duplicative jurisdiction. Duplication can be costly and inhibit innovation. Hence, one of the most important steps in any reform plan should be to remedy regulatory gaps and overlaps.

Regulation of OTC Derivatives

Credit default swaps ("CDS") and other financial derivatives are one good example. These instruments played an important role in the recent market crisis. Current estimates are that the credit default swap market alone may have exceeded $55 trillion in notional value.9 And yet, despite its enormous size and systemic importance, the Commission is explicitly prohibited from regulating much of the over-the-counter ("OTC") derivatives market.10 Among other things, this prohibition constrains our ability to require appropriate disclosures, such as position and trade reporting, as well as information regarding counterparties. I believe that the Commission should be authorized to exercise jurisdiction over all OTC financial derivatives that have a significant impact on the debt and cash equity securities markets.

Accordingly, I support the repeal of statutory prohibitions in the Commodity Futures Modernization Act of 2000 on the federal regulation of swap agreements.11 I also believe that systemically important instruments should be subject to centralized, mandatory clearing. Establishing central counterparties for credit default swaps would be an important step in reducing the counterparty risks inherent in the CDS market, and thereby help to mitigate potential systemic impacts. The Commission has taken important steps in this direction, and I look forward to continuing our work in this area.12

Regulation of Hedge Funds and Hedge Fund Advisers

Hedge funds also are a powerful illustration of problematic regulatory gaps. In recent years, hedge funds have played an increasingly significant role in our financial markets. They can contribute to liquidity and price discovery and provide investors with opportunities for portfolio diversification and capital protection in down markets.13 However, hedge funds also pose potential risks to investors and to the stability of the financial system.14

The Commission currently lacks basic data about hedge funds and hedge fund advisers, such as information about how many hedge funds operate in the United States, the size of their assets, their performance returns, and who controls them. Thus, it lacks significant knowledge concerning an important segment of the market. In addition, because hedge funds and hedge fund advisers are not required to register with the Commission, they are not subject to our periodic examination program. This makes it much more difficult for the Commission to identify misconduct prior to significant losses occurring.

I believe that the Commission should have clear authority to require hedge fund managers to register as investment advisers.15 The costs and benefits of imposing obligations on hedge funds themselves, such as requiring them to use an unaffiliated custodian and subjecting them to leverage limitations and net capital ratios, also should be considered. At a minimum, I believe, hedge funds acting as active market liquidity providers should be regulated as dealers under the federal securities laws. The "shadow financial system," which includes hedge funds and unregulated financial instruments such as certain OTC derivatives, is a source of significant systemic risk. We need to determine the most effective and efficient way to establish mandated standards of transparency and accountability in this largely unregulated area.16

Merger of the SEC and the CFTC

As a final example, consider the regulatory division of responsibilities between the SEC and the CFTC. The regulation of the securities markets and the futures markets is currently split between the two agencies. They have engaged in a decades-long dialogue about which agency has jurisdiction over a particular product.

I believe that Congress should seek to merge the regulatory oversight responsibilities of the SEC and the CFTC in order to provide more comprehensive oversight of the futures and securities markets. This would enable the merged agencies to obtain consolidated real-time information over markets that have become highly interrelated. In addition, as financial products become increasingly indistinguishable in economic function and purpose, it is very difficult to determine their regulatory treatment. Agency disputes over products that straddle regulatory boundaries serve neither the interests of investors nor the efficiency and competitiveness of our financial markets.

Of course, I could point to other regulatory gaps and overlaps. However, let me move on to the next principle, which is actually a subset of the previous one.

Principle 3: Consumers should receive the same level of protection when they purchase comparable products and services, regardless of the financial professional involved.

Financial markets, firms, participants, products, and services have converged, consolidated, and globalized to diminish the relevance and effectiveness of many of the current regulatory lines. These trends have also blurred investors' appreciation and understanding of the role of various financial intermediaries, the differences between the products they offer, and the protections they afford.

I believe reform is needed to address the regulation of all financial intermediaries. To take just one example, currently, broker-dealers and investment advisers are regulated under different statutes, and sometimes by different regulatory bodies, even though they often provide similar products and services to investors.

There is something fundamentally—or should I say functionally?—wrong with this. When your Aunt Millie walks into the local financial professional to ask for advice, she has no idea—nor should she—which set of laws governs the conduct of the person on the other side of the table. What she does need to know is that no matter who it is, or what product he is offering, she will receive a comparable level of protection. I don't think that we can give Aunt Millie that assurance today.

The burden should not be on investors to understand the nuances of the various protections afforded by different regulatory regimes. Improving the quality and timeliness of disclosure to investors is certainly important, but it will never fully address investor confusion regarding the duties and obligations of various financial intermediaries. Only consistent regulation will do that. Accordingly, I believe that every financial intermediary that offers a comparable product or service should be regulated in a substantially similar way, regardless of its primary regulator.

Principle 4: Important gatekeepers should be regulated to minimize conflicts of interests, increase transparency, and foster competition.

Gatekeepers act as "reputational intermediaries" who provide important services that benefit investors. For example, credit rating agencies evaluate the creditworthiness of a company, outside auditors provide independent assurance that a company's financial condition is portrayed fairly, and securities analysts assess its business prospects. These intermediaries play crucial roles in our markets because they are better positioned to gather information about companies than most investors are. Accordingly, investors rely on these gatekeepers. When their independence and integrity are called into question, market confidence suffers.

In the interest of time, I will focus only on the first gatekeeper—credit rating agencies, though the others are also important.

It is clear that the importance of credit rating agencies to the markets has far outstripped the amount of oversight they receive. They played a key role in the current market crisis. It is well known that the crisis began with deteriorating mortgage lending practices, particularly in the subprime area. There was an almost complete collapse of mortgage underwriting standards, which was most obvious in the notorious no-down payment loans and "no-doc" loans in which borrowers were not required to disclose income or assets, and even their employment was not verified. Through the process of securitization, underwriters packaged these risky loans into products that carried top credit ratings issued by the leading credit rating agencies. However, it was often nothing more than, in the words of Gilbert and Sullivan, "[s]kim milk masquerade[ing] as cream."17 While advertised as a way to diversify and thus reduce risk, these financial instruments were often poorly understood and far riskier than their credit ratings suggested. Investors and the markets paid a heavy price for this failure.

As you may know, the Commission recently adopted new rules relating to the oversight of nationally recognized statistical rating organizations ("NRSROs").18 The rules were in response to the requirements of the Credit Rating Agency Reform Act of 2006 ("Rating Agency Act"), which was enacted to improve ratings quality for the protection of investors by fostering accountability, transparency, and competition in the credit rating agency industry. Among other things, the Rating Agency Act requires a credit rating agency seeking to be treated as an NRSRO to implement procedures to manage the handling of material nonpublic information and conflicts of interest.

While the Commission has taken a number of important steps to address conflicts of interest in the credit rating agency industry,19 there is more work to be done. In particular, we need to examine more carefully how the rating agencies are compensated, how they manage conflicts, and what role they should play in our markets. I am especially interested in focusing on the conflict of interest that arises from the compensation scheme of certain credit rating agencies that charge issuers for their ratings. While this practice has long provoked criticism, these concerns were often downplayed based on the reasoning that credit rating agencies would have an "overriding incentive to maintain their reputation for high quality, accurate ratings."20 Recent events, however, have called that reasoning into question. I believe that we need to consider alternatives to the issuer-pay model. I'm open to all ideas, but one possibility would be the creation of a revenue pool out of which credit rating agencies could be paid. Such a proposal might go a long way toward ensuring the independence of credit rating agencies.

Finally, a fifth and last principle—at least for this afternoon.

Principle 5: No matter what new shape is constructed for financial regulation, it must incorporate strong enforcement powers for regulators to pursue wrongdoing and deter future misconduct, but those powers must be in addition to—not in lieu of—regulatory authority.

Enforcement is often the Commission's most public face. Every year the Commission initiates hundreds of enforcement cases to impose penalties for and remedy violations of the federal securities laws, ranging from financial fraud and insider trading to market manipulation such as abusive short selling and pump and dump schemes. The securities self-regulatory organizations bring hundreds more cases and the Commission assists law enforcement agencies in the United States and around the world with criminal cases. Vigorous enforcement is critical, especially in times like these when investor confidence has been so badly shaken. Enforcement is the most visible way in which the Commission makes sure that market participants understand the boundaries of legal conduct and deters potential wrongdoers and recidivists from crossing those lines.

However, the Commission's focus on enforcement cannot be exclusive. For nearly 75 years, the Commission has been charged with the protection of investors and the maintenance of fair and orderly markets. More recently, Congress has charged the Commission to consider competition, efficiency, and capital formation in its policies and rulemakings. This mission is more vital than ever in today's marketplace. The Commission's rule writing and filing review functions, to pick just two examples, are critical to establishing high standards of conduct and to preventing fraud and other wrongdoing. Performing non-enforcement functions will also help to avoid the necessity for enforcement, which cannot always make those harmed whole.

Conclusion

In closing, I hope that, while not a comprehensive plan to restructure the financial system, the five principles I have highlighted today can provide some guideposts for that plan as we all—Congress, regulators, industry, and investors—sit down together to determine what regulatory structure makes the most sense in the 21st century.

I have enjoyed being with you today. I would like to conclude with an invitation: If any of you would like to discuss these issues or any other matters with me, please remember that my door and telephone lines are always open.

Thank you.

Endnotes

1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission, other Commissioners, or the staff.

3 See Congressional Oversight Panel for the Troubled Asset Relief Program, Special Report on Regulatory Reform, Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability (Jan. 2009) (hereinafter COP Report), available athttp://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf; U.S. Government Accountability Office, GAO-09-216, Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System (Jan. 2009), available athttp://www.gao.gov/new.items/d09216.pdf; and Group of Thirty, The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace (2008).

9 The Bank for International Settlements estimated that the notional amount of outstanding CDSs in 1998 was approximately $108 billion. By 2007, that number had grown to approximately $58 trillion. See Bank for International Settlements, Press Release, The Global Derivatives Market at End-June 2001 (Dec. 20, 2001), and Bank for International Settlements Monetary and Economic Department, OTC Derivatives Market Activity in the Second Half of 2007 (May 2008).

10 The Commission has limited direct authority to regulate the over-the-counter credit derivatives market, which includes credit default swaps. The Commodity Futures Modernization Act of 2000 ("CFMA") amended the Securities Exchange Act of 1934 ("Exchange Act") to exclude all qualifying swap agreements from the definition of security, but gave the Commission antifraud authority (including authority over insider trading) over "security-based swap agreements." See Exchange Act Section 3A. Section 206B of the Gramm-Leach-Bliley Act defines "security-based swap agreement" as a swap agreement in which "a material term is based on the price, yield, value, or volatility of any security or group or index of securities, or any interest therein." Despite this grant of antifraud authority, however, Congress specifically prohibited the Commission from promulgating, interpreting, or enforcing rules, or issuing orders of general applicability, in a manner that imposes reporting or recordkeeping requirements, procedures, or standards as prophylactic measures against fraud, manipulation, or insider trading with respect to any security-based swap agreement. See Exchange Act Section 3A(b)(3).

12 See Exchange Act Release No. 59246 (Jan. 14, 2009) (Temporary Exemptions for Eligible Credit Default Swaps to Facilitate Operation of Central Counterparties to Clear and Settle Credit Default Swaps (Interim Final Temporary Rule)), available athttp://www.sec.gov/rules/final/2009/33-8999.pdf; see also The Role of Credit Derivatives in the U.S. Economy Before the H. Agric. Comm., 110th Cong. (2008) (Statement of Erik Sirri, Director of the Division of Trading and Markets, Commission), available athttp://www.sec.gov/news/testimony/2008/ts101508ers.htm.

15 In December 2004, the Commission promulgated a rule that required hedge fund managers to register under the Investment Advisers Act of 1940 and comply with adviser regulations, including filing disclosures, adopting a compliance program and a code of ethics, and being subject to SEC examinations. See Investment Advisers Act Release No. 2333 (Registration Under the Advisers Act of Certain Hedge Fund Advisers) (Dec. 2, 2004), available athttp://www.sec.gov/rules/final/ia-2333.htm. However, in June 2006, the U.S. Court of Appeals for the District of Columbia Circuit vacated the rule. SeeGoldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

16 See COP Report, at 30-33 ("Extending the reach of financial regulation to cover the shadow financial system is necessary in order to accurately measure and manage risk across the markets. A consistent regulatory regime will also reduce the ability of market players to escape regulation by using complex financial instruments….").